Credit Unions + Alternative Investments: Can It Be Done?

With trillions of dollars in government spending over the past year, financial institutions have been flooded with cash and new found liquidity. Credit unions are generally seen as conservative investors with their excess liquidity. Many will invest in certificates of deposit, lower risk bonds, and may even enter into mortgage backed securities. Because of the excess liquidity all across the board, investment returns in these products have been very low. Of course credit unions are expected to lend the money out and earn a return from the interest received from these loans, but as the world begins to climb out of the COVID-19 pandemic, we are beginning to realize that several factors could begin to create challenges to the lending environment.

There are three key areas that could affect lending for the short to intermediate future:

1. Weakened global supply chains creating shortages of raw materials and consumer goods

2. Growing inflation for cost of goods

3. Low interest rate environments compressing yield spreads

These three areas could have a major impact on smaller financial institutions. Even credit unions that take on greater credit risk in order to charge higher interest rates could begin to see a down turn as housing supply cannot keep up with housing demand, independent auto dealers continue to struggle to obtain used auto inventory to sell, and a lack of demand for unsecured loans due to the influx of cash from stimulus payments. Even with a low rate environment (which should encourage borrowing), the larger financial institutions will have the strength to outbid smaller institutions by going extremely low with their rates and pricing many credit unions out of deals. Where can the smaller institutions go to find yield or revenue? More credit unions have embraced non-interest income by offering different insurance products to their members or reevaluating their fee structures. This still does not solve the issue of what the credit unions can do with excess liquidity and to stabilize their capital ratios. How do we continue generating revenue while the world continues to recover from COVID-19?

If lending slows and traditional investment options are not providing sufficient return, then where else can the credit unions invest? Many have turned to indirect auto lending. Many credit union executives will rationalize paying 3%-5% dealer reserves to earn 2%-4% on high credit score loans by simply stating “It earns more than a corporate CD”. Perhaps those executives are right, but I think that there is a better and more profitable path:

Alternative Investments aka Crowdfunding

NCUA, state regulators, and deposit insurers have been hesitant when it comes to credit unions taking on risk in their investment portfolios. In the past, there has been discomfort when it came to credit risk in lending portfolios, but the waves of change have led to more credit unions taking on more risk with lending and regulatory bodies becoming more comfortable in that space. So what does risk look like in a crowdfunded investment portfolio?

Crowdfunding has become a popular investment vehicle for many individual investors. I have dedicated roughly 10% of my own personal investments to these “Alternative” options. Crowdfunding provides financing to borrowers who generally cannot get traditional financing. Popular crowdfunding deals have included investment agricultural loans, supply chain funding, short term note packages, and speculative residential projects. These opportunities generally have asset backed collateral, but the risk can be that some of these projects are in subordinate lien positions or are located in geographic areas beyond a regional credit union's space. Other risks include having no contact or little knowledge of the borrowers as well as working with firms with track records that only go back a few years.

As I have begun to research and do additional due diligence, a few of these alternative investment firms would welcome an influx of corporate and institutional investing. Several of these firms are doing projects that can earn anywhere from 4% to 10%. Some are longer term investments, some are shorter term. The fact is, when our only option is to over pay for low yielding loan participations, low yielding (also long term) mortgage backed securities, and ultra-low yielding certificates, we need to be open to new and fresh ideas. Some state regulators have a “wild card” provision that allows credit unions to invest a small amount into investments that would generally be considered “off-limits”, but even when credit unions attempt to utilize this provision; many are met with disapproval or significant concern that may show up in an exam report.

The process does not happen overnight. Regulators and deposit insurers will need help to become more comfortable with these types of investments. Credit union boards of directors will need to approve of new strategies. ALM models and concentration risk policies will also need adjusted. With that said, for those institutions feeling a down turn in lending (or have always struggled to lend), crowdfunding or alternative investment options become appealing. Extensive due diligence needs to be done on each project and a strong background check needs to be done on the firm facilitating the deals, but in the end, how is this really different than how many credit unions currently do member business lending? Do we not work with a centralized company who presents a deal to us while attempting to crowdfund a business loan from several other credit unions? Is the current MBL participation model just a fancy way of saying that we crowdfund business loans?

The credit union industry has seemingly found a way to stay ahead of the curve in so many aspects of business. We find creative solutions to problems and find ways to succeed. Our greatest strengths are speed and flexibility. This could be the next big thing for credit unions to take the lead on, but can it be done? Only time will tell, but I intend to find out!